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How a Bull Can Trade a Bear Market in Oil

How a Bull Can Trade a Bear Market in Oil

Oil prices continue to fall. A barrel of crude oil is now below $45. It wasn’t that long ago that crude traded above $110 a barrel. In 2013, analysts warned that the world was running out of oil and we might not ever see oil fall below $100 a barrel. Well, as the chart below shows they were wrong.

Now, with oil setting new 52 week lows, analysts are again making bold forecasts. Not surprisingly, they are following the trend and their forecasts are bearish. Among the recent forecasts is a report from analysts at Guggenheim.

Last week, they cut their forecast for oil prices this year to $48 from $55. Adding to the bearish tone, they added that they aren’t looking for a recovery in oil priced until the second half of 2018.

Seasonals Are Also Bearish

There are other factors that could weigh down the price of oil, at least in the short term. Like many commodities, crude oil follows a distinct seasonal pattern. It is important to remember the seasonal pattern is in pricing, not in consumption or production.

The next chart shows the seasonal pattern in crude oil pricing. As the chart shows, the seasonal pattern is bullish for about six months and then bearish for about six months. Right now, we are at the beginning of the bearish seasonal trend in crude oil.

This chart uses data from the past ten years and longer term charts do show a different pattern. Using too much data can provide a misleading picture of the seasonals in crude oil. The industry has changed a great deal in the past ten years. New technologies, particularly the widespread adoption of hydraulic fracturing or fracking, has dramatically increased the supply of the economy.

Fracking has changed the market. By creating a new source of supply, adoption of the technology generated pressure on prices. This makes it more difficult for producers to operate profitably. As profits declined, an industry shakeout occurred with weak producers entering bankruptcy.

These changes in the industry may not be permanent. But, these changes do have a long term impact on the oil sector. Fracking has redefined the industry and that has redefined the investment environment in the energy sector.

Digging Deeper Into the Sector

We know that oil is in a bear market, that seasonals are bearish and that the investing environment in energy is different than it was a decade ago. We can no longer simply buy oil producers and expect rising commodity prices to deliver a profit. But, there are still ways to profit from the sector.

To see how the industry changes have created opportunities, we need to consider fracking. No matter how low the price of oil falls, there will be drilling. And, there will be companies that benefit from drilling. This idea is similar to the famous idea of selling picks and shovels to the miners in a gold rush.

Fracking is a complex process. It involves drilling, injecting liquids and solids into the drilled holes in order to open up fractures in the rock, and then pushing the oil and gas through the fractures to the surface.

There are a number of companies involved in producing supplies for the drillers. Among the most interesting supplies is sand. Sand is one of the solids that is pushed into the fractures to keep them open so that the oil and gas can be recovered. It turns out sand is one of the most important supplies in the fracking fields.

No matter what the price of oil does, demand for sand is increasing. The total projected industry demand is for about 75 million tons of sand for this year and more than 100 million tons in 2018. If the price of oil recovers, demand for sand could be even higher.

There are a few companies that are profiting from the demand for sand. Among them is U.S. Silica Holdings, Inc. (NYSE: SLCA). Analysts expect SLCA to report earnings per share (EPS) of $1.67 this year and $3.55 in 2018.

With a price to earnings (P/E) ratio of 15, the long term average P/E ratio for the stock market, based on next year’s estimates EPS, SLCA could be worth about $53 a share. This is a potential gain of more than 60% from the current price of SLCA.

One reason for the steep discount to its potential value is the company’s association with the oil sector. In fact, as oil sold off, the price of SLCA declines. But it recovers quickly when oil turns up and recovers much more than oil does in the up swings.

Options for Long and Short Term Trades

The chart for SLCA shown above indicates the stock price is likely to deliver a large gain when the price of oil recovers. The stock could certainly trade for more than $50 a share if the price of oil recovers in the second half of next year as analysts at Guggenheim forecast.

This sets up a simple options trade. Buying a call can allow investors to profit from a price gain. One challenge with buying calls is getting the timing right. Call options expire and buyers generally need the price gain to happen to before the option expires.

Options with many months to expiration can reduce this risk. For SLCA, there are options with an expiration date of January 18, 2019. The January 2019 $30 call is trading at about $9.65. If SLCA reaches $50 before this option expires, the option should trade for at least $20. This trade provides a long term trader with the opportunity to double their investment.

Each options contract covers 100 shares so the cost to enter this trade would be about $965, ignoring commissions which are usually rather small at deep discount brokers. This amount of investment could be a hurdle for smaller investors to overcome.

A shorter term strategy could also be profitable and would require a smaller capital outlay to open. A trader can always use a series of short term trades to maintain exposure to a particular stock. In this way, by opening new trades when one expires, the trader could generate large gains over time.

For SLCA, there are options that expire on July 21, in less than two weeks.

The stock closed at $31.23 on Friday, after falling 9.6%. The high volatility for the day increased the premiums of options.

A put selling strategy is a bullish trade. But the risks of selling puts can be high. To reduce the risk of that strategy, a spread can be used. This involves selling a put to generate income and buying a second put to decrease the risk.

In SLCA, the July $29 put could be sold for $0.60 based on Friday’s closing price. The July $27 put can be bought for $0.27 at Friday’s close. The combined transaction generates $33, the difference between the price of the option sold and the price of the option that was bought.

The risk on the trade is equal to the difference in the exercise prices less the income received, or $167 in this trade. The $33 potential gain of an investment of $167 is a return of about 15.3% in less than two weeks.

When the July puts expire, August puts could be sold to maintain exposure to SLCA and to generate additional income. This strategy could be used for many months to duplicate the strategy of buying the stock or a long term call option.